Philip Morris International Valuation
Valuing Philip Morris using the earnings power and growth return approaches
British American Tobacco BTI 0.00%↑ is one of my largest holdings so I have been wanting to study the other two major tobacco companies: Philip Morris International PM 0.00%↑ and Altria MO 0.00%↑ . Since BTI and Philip Morris are similar companies, I thought it would be straightforward to update my BTI earnings model with PM financial data. After applying the earnings power valuation method on PM, my fair value estimate was wildly off from where the current market price is at. This means the market is way more optimistic on Philip Morris than what my calculations would suggest. In order to gain a different perspective, I then tried to value PM using the growth return method that is reserved for high quality companies. This produced a result more in line with what how the market is pricing the stock. Despite getting a valuation that more closely matched the stock price, I felt that it was inappropriate to use the growth return method on Philip Morris.
Warren Buffett often talks about companies having an economic moat, which is an analogy for the defense a company has against competition in the same way a moat protects a castle. Some high quality businesses have economic moats that result from the ability to offer a product or service in a way that it is very difficult for competitors to enter the market, thereby providing high returns on assets and sustained sales growth. Tobacco companies used to have moats, but I feel that they no longer benefit from them. So after feeling unsatisfied with applying the growth return valuation method on Philip Morris, I spent some time philosophizing whether or not Philip Morris has a moat
Earnings Power Valuation
For BTI I have used the earnings power valuation method that does not include any growth in revenue or earnings. In Bruce Greenwald’s Value Investing, he distinguishes between companies that have a competitive advantage (economic moat) and those that do not. If a company has a competitive advantage, it can generate high return on assets, as well as reinvest profits back into the business for growth. Tobacco companies used to have a competitive advantage, were consistent growers, and because of regulations there exists barriers to entry that limits competition. That has changed with the secular decline in cigarette volumes. I think BTI is a good business, but I do not think cigarette sales provide an economic moat. As I will discuss later, the new smokeless tobacco products may or may not provide an economic moat
This is all to say that I value BTI based on an estimate of normalized earnings, so I figured it would make sense to do the same with Philip Morris. Jumping into PM’s valuation, I estimated their 2024 revenue to be $36.5B, slightly more conservative than the guidance management issued. Next I applied a 35% operating margin, which is a couple percent higher than 2023 but in line with historical margins. Then I used a 25% tax rate to get an estimated after tax earnings of $9.58B.
Now that I have an estimate earnings figure, it is time to capitalize it based on a reasonable cost of capital. For this I assume a cost of debt of 5.2% and a cost of equity of 8%. Based on Philip Morris’ typical capital structure, I get an average cost of capital of 7.1%. Dividing the estimated earnings by the cost of capital gets and enterprise value of $135.4B. Next the enterprise value is adjusted for the debt and cash positions to get an estimated equity value of $91.1B. Finally dividing by the number of shares outstanding gets us a fair value of $58.75.1
This fair value is much lower than the current market price of $115, which makes me wonder if I am using the wrong valuation approach, or if the stock is massively overpriced. To gain a different perspective, I tried valuing PM based on the growth method described in Greenwald’s book.
Growth Valuation
This valuation method is a bit different because it implies that you are buying a quality company and holding it for a long period of time (think of Buffett buying Coke-Cola in the late 80’s). Instead of calculating a fair value of the stock, this method estimates the amount of return the investor might achieve. In short, you estimate the amount of earnings the company can distribute to shareholders. Then you divide that distributable earnings by the current market cap to get a distributable earnings yield. Next you add onto the yield figure the estimated organic growth of the company. This organic growth is the increase in revenue from general GDP growth, demographic changes, or some industry that happens to be growing, ie growth factors that are beyond the company’s control. The last step is to add another growth rate, this one being the growth generated by the company reinvesting its profits.
The distributable earnings yield is straightforward because it is practically the same process we did above. However there should be a good amount of thought that goes into the organic and reinvestment growth figures. Unfortunately, digging into the nuances of these growth figures is a task for another day. Instead, I am going to use some quick growth estimates to see where we end up.
In the earnings power method, we estimate earnings without factoring in debt payments in order to get an enterprise value, which is then adjusted for debt to get the equity value. For this method, we repeat the same earnings calculation but subtract $1.5B in interest payments to get earnings of $7.9B. Philip Morris pays out most of their earnings as dividends, so for this example we will assume they pay out 80% to shareholders. That gets a distributable earnings of $6.3B, and dividing by the current $175B market cap, we arrive at an distributable earnings yield of 3.6%.
For growth, I referenced Morningstar’s analyst report that estimates 5 year revenue growth to be 7%. This may be reasonable if you assume cigarettes volume decline but PM is able to increase profits to basically keep up with inflation, let’s say a 3-5% growth rate. Cigarettes are currently 70% of revenues, with vapor, heated tobacco, and tobacco-less nicotine pouches making up the rest. These new products are growing at a high rate, but since they are a smaller part of revenue, and are not as profitable as cigarettes yet, they only modestly add to this growth figure. So with this back of the napkin math, it seems like 7% revenue growth rate is plausible.
Taking the 3.6% distributable yield and adding the growth assumptions gets an estimated return on investment of 10.6%. The next step in the process would be to compare this return to the broader market to see if it is worth investing in this stock or just buying the market. Without getting into what potential growth returns from the S&P 500 are, lets just say that PM seems fairly valued with these assumptions.
To recap, using the earnings power method assuming no growth produces a fair value that is way below PM’s current stock price, while the growth return method seems to produce a reasonable figure. Just for further context, PM is trading for around 20x earnings, while BTI is trading for about 10x earnings. What I think this really comes down to is that the market is expecting, and pricing in, high growth figures for Philip Morris because of the currently dominate Zyn nicotine pouch and the IQOS heated tobacco device that is popular overseas. Like I said, if the growth assumptions are true, then you can argue PM is fairly valued. However in the next section I want philosophically discuss whether or not it is reasonable to use this growth return method in valuing Philip Morris.
Philip Morris’ Economic Moat
Even though it appears the market is pricing Philip Morris (and not other tobacco companies) for decent growth, using the growth return valuation method leaves a bad taste in my mouth. Yes PM has had high return on assets, suggesting a moat, and tobacco companies certainly used to have a moat, but I still lean towards they do not.
This is muddied by the fact that Philip Morris have this declining legacy cigarette business, but also a faster growing modern nicotine product lines (the other major tobacco companies have their own modern products as well). Greenwald states that the growth return approach should only be used on the parts of the business that actually has a moat. So I think it is wise to look at both business segments to determine whether or not they deserve moat status.
The key assumption with the cigarette business is that volumes will decline about 5% a year, but the tobacco companies can raise prices. This should hopefully allow sales to generally track inflation. I think this assumption tracks on a 5 year time horizon, but I feel less confident making that forecast over 20 years. Additionally, the cigarette business requires practically no reinvestment of profits, so most of the profits returned to shareholders. Sales of cigarettes produce high returns on assets, and there is limited competition, so maybe there is a moat. But in this case, even if there is technically a moat, the low growth rates, and long term uncertainty of those growth rates suggest to me that the earnings power valuation method is more justified.
The new industry of modern nicotine products have seen decent growth rates, and Philip Morris’ Zyn product in particular has been leading the charge. These modern products include vapor devices, heated tobacco, and nicotine pouches. Since these are new products, it remains to be seen which category will dominate in market share. The picture I am trying to paint is that this industry is very volatile right now, where we don’t know if vape or pouches will be the leader, let alone whether Zyn or Velo will be the leader. I get the impression that analysts see the nicotine pouch market as winner take all, with Zyn winning. But even if Zyn has the largest market share, there could be room for competitors as they differentiate on the level of product quality, price points, targeted demographics, etc., just as there are dozens of cigarette brands despite Marlboro being the best selling.
Additionally, these modern nicotine products have generally been unprofitable for the tobacco companies until recently. This is a nascent industry so it makes sense that extra money has to be spent in R&D, marketing, and manufacturing, causing these products to lose money at the moment. So if the idea is that growing companies with moats receive this designation by reinvesting profits to drive higher growth, we are not at this stage yet with the modern nicotine products.
My last point will be that 30 years ago you could have easily appreciated that Coca-Cola is an universally enjoyed product that would face tailwinds as it expanded sales across the globe. With the modern nicotine products, analysts can assume that they will grow for a long period as smokers transition to these products, or maybe non-smokers contribute to some of the growth. This is probably a fair assumption, but there is always the possibility that these new products plateau instead of continuously growing for 20 years.
In conclusion, while the smokeless products are growing nicely, I remain unconvinced that they currently have an economic moat. Therefore, based on my valuation framework, I do not think it makes sense value PM as if it is a high growth company with an economic moat. However this is maybe just a theoretical exercise of me trying to shoehorn Philip Morris’ current stock price into my framework, while another analyst would just use whatever valuation method gives them their desired price target and call it a day.
As an aside, if you used a cost of capital of 5% instead of 7.1%, the fair value becomes $95, which is in ear shot of the current market price. I think using a cost of capital of 5% is absurd when short term treasuries provide yields in the 4-5% range, which is way more safe than a tobacco company. A lower cost of capital may have made sense when interest rates were at record lows, and maybe it makes sense if rates go back low, but I do not think it is currently valid.